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Austerity alone won't save Europe

The EU debt crisis calls for a mix of short-term stimulus and medium-term fiscal constraint, but the political prejudice of economists is slowing progress.

President Truman famously complained that his economists always gave advice in terms of 'on the one hand...on the other hand', and called for a one-handed economist. This criticism doesn't apply to the current bunch of economic commentators, all single-minded in their views. The problem is that they advocate diametrically different policies.

Let's take a relatively clear-cut policy issue. Sovereign debt is widely accepted to be too large in most European countries. But if debt is reduced through budget austerity, in the short run the economy will slow even further. On OECD forecasts, unemployment in the euro area will still be over 10 per cent at the end of 2013, and tougher austerity would see it even higher, with youths bearing the brunt. More seriously for this strategy, when the economy slows, taxes fall and social expenditures (unemployment benefits, health care, pensions) rise.

Hence, it is very difficult to improve the debt/GDP ratio by austerity alone.

Of course, it could be done if the politicians are tough enough (Thatcher did it in the UK in the 1980s). But it is highly unlikely that voters will give this strategy time to work. Any politician brave enough to try this strategy will see the benefit go, years later, to an alternative government.

Thus the more feasible way of getting the debt ratio down is by increasing the denominator, through economic growth and/or inflation. When the economy is growing at a reasonable pace, the budget can be trimmed counter-cyclically, with the help of the automatic stabilisers: social expenditures fall and taxes rise.

For this one-handed economist, it's clear that austerity can't fix Europe's problems (although getting the budget into surplus should be the central element of the medium-term policy commitment). And there are others on this side of the argument. On the other hand...

...noted Harvard economist Martin Feldstein (you may recall his cameo appearance in 'Inside Job') claims that if Italy just did a decent job with its budget, nothing more (specifically, no support from the European Central Bank) would be needed. Financial markets would quickly see that Italian debt was low risk and would put interest rates down again.

Actually, Italy has done a better job than most European countries with its budget: it has a primary surplus (ie. before interest payments) and only 10 years ago demonstrated its capacity to get the debt down, under more benign economic conditions.

No doubt there are things that can be done now to improve Italy's budget, even in the short-term. But if this is done at the expense of growth (currently forecast by the OECD to be negative next year and barely positive the year after), it's hard to see that the current technocratic government will be given time for its strategy to bear fruit. ECB support for Italian bonds is needed now.

Other academics have weighed in, backed by the rigorous logic of economic models. Daniel Gros argues that debt reduction must succeed, probably in the short term, and definitely in the longer-term (A botched Berlusconi decade, November 9). The problem is that his simple model leaves out the vital link: cutting expenditure doesn't just affect income through the text-book multiplier. As explained above, there is also feedback that makes the budget deficit (and hence debt) worse.

But for Gros, this is not a problem. His model says that the economy has strong self-righting properties that will take GDP quickly back to the original trend growth path. The possibility that this takes considerable time, and that years of unemployment will actually lower the economy's productive potential, isn't part of his model.

Perhaps the most disturbing feature of these differences of prescription is that they seem to be largely based on political affiliations. We know, from his US writing, that Feldstein will always favour tough austerity (though not, mind you, by taxing the rich). Just as, on the other side of the US debate, Paul Krugman will favour increased budget expenditure, without being too specific about just how the longer-term problem of excessive government debt will be handled.

Perhaps if Truman were President today, he would be asking for an economist who could give advice based on the state of the economy, not political prejudice.

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